The last two months of 2005 showed a pick up in the U.K. housing market with increased lending and transaction activity as well as rising home prices. These factors indicate that U.K.'s housing market may be in store for its first-ever soft landing. However, David Miles, Morgan Stanley's chief U.K. economist, says there may be more downward adjustments in store for 2006.
Home prices, which had been flat to falling in the first half of 2005, moved up towards the end of the year. Halifax reported a 1% rise in house prices during December, while Nationwide Building Society said prices increased by 0.5% - both reported an above average monthly gain for 2005. Miles estimated a steady rise of about 2% to 3% for the last three months of this year, with prices in the U.K. ending up slightly higher on average in real terms.
"Transactions have really followed the same pattern as those prices," he said. "In the first half of 2005, the level of overall transactions was running substantially down than where it had been during the same period of 2004 - by as much as 24%." By the second half of the year, transactions had also picked up significantly. The overall level of transactions in 2005 - although down from 2004, which was an unusually active period - does not look out of line with the level of transactions over the last four or five years on average, Miles said.
Simultaneously, lending picked up during this period with the number of approvals for loans rising steadily by midyear, painting an overall dream scenario that is expected to send the U.K. housing markets into a soft landing. "The Bank of England would have wanted the level of house price inflation to fall and would have wanted to avoid a collapse in transactions, in lending or in prices, which would have triggered larger problems in the economy," explained Miles. If the housing sector continues to behave as it has, he said, "we would have seen the first soft-landing in U.K. history, where typically the story has been periods of prices rising sharply followed by sharp falls and lower transactions and mortgage lending falling sharply as well."
But Miles cautioned that it is still too early to declare victory because valuations remain stressed. The area where this shows up most clearly is in the buy-to-let market, where the economics don't make sense. "Look at the prices on the kind of property you would buy to rent out and the kind of rent you would get - that gross rental yield is no higher than the cost of borrowing," he said. "The gap has been 3% to 4% on average over the last 10 years but it has shrunk to virtually nothing."
Miles expects that this segment of the U.K. housing market will likely play less of a role over the next six months to a year and will need to be replaced by some other area of growth. "Another source of demand will have to increase to fill the gap in buy-to-let demand, which has been important in the U.K. markets in recent years," he said. The natural source of demand would point to the first-time buyers market, which, with soaring house prices over the past years, has been gradually left by the wayside.
Miles said that prices have not moved in real terms and still remain relatively high in relation to incomes of first-time buyers. "The market may need some price adjustment to bring more first-time buyers to fill the gap," he said. "It would not surprise me if the level of house prices might yet drift lower over the next year or so."
All the other pieces of the economy are in place to keep the housing market on track for a soft landing. Adding to the benign outlook is the absence of any signs that the overall U.K. economy is experiencing a degree of deterioration that would trigger a sharp adjustment in house prices, said Miles. The reported slowdown in consumer spending is likely a temporary adjustment and not a harbinger of an overall economic slowdown, he added. And while the level of unemployment has picked-up slightly, Miles said it was important to view it in the context of a very low level of joblessness in the U.K. over the past few years.
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